Market and Economic Outlook - Released 3/31/23

Key Takeaways:

• Given there is a significant amount of uncertainty moving forward, we believe it makes sense in the current environment to position multi asset portfolios neutrally between stocks and bonds.
• We currently view this as an opportunity to adjust portfolio exposure, seeking value in quality stocks over more speculative stocks.
  
• Income investors are no longer forced to take substantial credit risk to earn a meaningful return. Given the higher likelihood of a recession, we believe it makes sense to have a bias towards high quality investment grade bonds.
  

Baseball great Ted Williams once said the most important thing in hitting a baseball is waiting for the right pitch. Williams, in his book, The Science of Hitting, dissected his batting average based on specific baseball sized sections covering the strike zone. He determined the greatest outcome for success was to hit pitches near the middle of the plate. If he waited for these pitches, he would have optimal results.

While not as skilled at baseball as Ted Williams, we do believe some of these lessons can be applied to the world of investing. We have never believed in market timing but patiently stand ready to take advantage of opportunities we deem attractive relative to our assessment of the risks. Today, we attempt to navigate the risks of possible persistent inflation, the lagged effects of the Fed raising interest rates on the economy, and the challenges we have seen in the banking sector.

Dissecting the Start of 2023

The first quarter has shown solid returns in most areas of the market with the S&P 500 index up 7.5%, international developed stocks up 8.6% and investment grade bonds up 3.2% (Figure 1). Equity markets quickly climbed in January, but lost steam soon after due to expectations for interest rate increases to continue their climb and remain higher for longer. The start of March quickly brought expectations for additional rate hikes back down, however, the failure of two regional banks brought to light the lagging effects of a swift tightening in monetary policy. While markets have calmed down in recent weeks, we should expect continued volatility as we move through the year.

The macroeconomic environment remains a mixed bag and there is still much uncertainty moving forward. The Fed is committed to bringing inflation down towards its target but is seemingly caught between a rock and a hard place. They have the difficult job of trying to tame inflation, while at the same time engineering a soft landing that doesn’t throw the U.S. into a recession.

Puts and Takes

On the positive side, the labor market remains historically strong with an unemployment rate of 3.6%, initial jobless claims are still under 200K, and non-farm payrolls have gained by 815,000 in the first two months of the year. The number of job openings remains plentiful as well with the most recent JOLTS report showing 10.8 million jobs still available. Retail sales sped up in January and at the end of February remained 5% higher than a year ago.

On the more challenging side of the equation, the most recent headline inflation reading, while having come down considerably from its highs, remains at 6% which is well above the Fed’s 2% target. We have also seen the failure of two banks, Silicon Valley Bank and Signature Bank, with recent rate increases a key ingredient in their failures. The Fed will need to navigate the desire to bring down inflation and the impact additional rate increases will have on the economy. Tough choices will lie ahead as the path toward a soft landing continues to be difficult.

While it remains to be seen if we will get a recession in the near future, the consumer remains resilient, and GDP growth is expected to be steady to start the year with the Atlanta Fed’s GDPNow model predicting a 2.5% increase for the first quarter. In this model, consumer spending is expected to add about 3.1% to the equation with private inventories detracting.

Despite an erratic quarter for U.S. stocks, valuations don’t appear like a pitch down the middle to us yet. Investors are unlikely to hit a home run in bonds, however we feel the risk reward in fixed income looks more attractive. Given there is a significant amount of uncertainty moving forward, we believe it makes sense in the current environment to position multi asset portfolios neutrally between stocks and bonds.

Lagging Sectors Shine

In almost a mirror image of 2022, in the first quarter of this year, we saw a strong rally in many sectors of the S&P 500 that underperformed by the largest margin last year (Figure 2). This includes the Communication Services, Consumer Discretionary, and Information Technology sectors. Investors who reduced exposures to these sectors in favor of stronger performing sectors like Energy and Utilities last year, for example, would have experienced additional underperformance from this trading strategy to start 2023. 

We believe this demonstrates the importance of portfolio diversification and avoiding market timing even within stock exposures as market dynamics can change very quickly for any number of reasons. As a result, we feel it makes sense to maintain varying magnitude of exposure across the universe of economic sectors in most environments. This is also why, despite the banking crisis and bank stocks coming under pressure, major indexes were still able to finish higher for the quarter.

We saw the rally in the above-mentioned sectors of the market as their share prices grew strongly, even as we continued to see earnings estimates for the S&P 500 decline. This puts pressure on valuations as their price to earnings ratio grows larger in this environment (higher share price, lower expected earnings). While stocks do not look egregiously expensive here, as we mentioned last quarter, we are still expecting an earnings recession in 2023 and see this rally as stretching valuations further. We expect additional pressure on bank earnings estimates as we start to dissect the magnitude of lost deposits due to the banking failures we saw in March, which may create further downside bias in earnings estimates for major US stock market benchmarks.

Quality and Profitability over Speculative

Considering this backdrop, we remain patient and continue to look for our pitches to hit. Given the modest rally we have seen in broad stock market benchmarks to start the year, we currently view this as an opportunity to adjust portfolio exposure, seeking value in quality stocks over more speculative stocks.

The clearest example for lower quality/speculative stocks to us is within a segment of U.S. small cap stocks. The number of unprofitable companies in the Russell 2000 benchmark of small cap stocks has grown steadily over recent years and now stands at around 42% (JPM). These smaller and unprofitable stocks could face greater pressure in a higher rate environment, and if we face an economic recession, their ability to raise capital to fund continued operations becomes more and more difficult.

As a result of this outlook, we have taken the opportunity to reduce our exposure to smaller cap stocks broadly in favor of their larger cap peers and remain focused on owning companies in both segments with a bias towards quality and profitability. We continue to have a neutral view on international stocks, despite strong performance to start the year, for the same potential risks we have discussed in recent quarters, and the risk of commodity price exposure in emerging market stocks.

Favorable Bond Yields Remain

Despite a steeply inverted yield curve, the investment opportunity in bonds remains attractive to us compared to riskier assets. One reason for this is the level of interest rates. The Fed has increased the Fed Funds rate by 4.75% in just over a 1-year period which has also caused longer-term interest rates to rise since March of 2022. Volatility related to the regional bank crisis in mid-March prompted investors to seek safe assets. This caused interest rates to decline from their recent highs but credit spreads, or the difference in the yield of two bonds with the same maturity but different credit quality, increased (Figure 3).

Earnings yield is the reciprocal of the P/E ratio and states how much a stock investor earns per share. It is often used to compare the relative attractiveness of bonds vs. stocks. Today, the yield of investment grade corporate bonds is higher than the earnings yield of the S&P 500 (Figure 4).

Income investors are no longer forced to take substantial credit risk to earn a meaningful return. Given the higher likelihood of a recession, we believe it makes sense to have a bias towards high quality investment grade bonds.

Don’t Abandon Duration

It was a successful strategy during 2022 to invest exclusively in short term fixed income securities. However, investors are incorrect in thinking they should only be allocating to Treasury Bills or cash equivalents instead of intermediate and long-term bonds. Cash has become a viable alternative for short term goals. However, it would be foolish to dismiss intermediate term bonds for longer term goals.

High quality intermediate term fixed income instruments allow today’s yields to be captured for longer. Yields on cash equivalent securities like Treasury Bills could be temporary, as they will be more susceptible to the Fed changing course and lowering rates. Duration, a measure of interest rate sensitivity of longer maturity bonds, may provide stability against volatility in a portfolio if we eventually enter a recession and rates fall. Based on quarter end yield to maturity and duration measures, a 1% fall in rates could lead to total returns of +10% or more for the Bloomberg Aggregate Bond Index. Higher yields can also provide a cushion to bond prices, relative to lower yields, if rates increase from here.

The Bottom Line

Investing is difficult because the outlook always appears uncertain. As any great hitter or investor knows patience is critical to long term success. There are times when the best plan, for even the greatest hitters, is to not swing for the fences, but to find a level of risk which makes sense for your goals and remain disciplined. We believe financial markets will remain challenged over the course of the year but are comforted by better yields provided by high quality income producing investments. Amidst uncertainty, a trusted advisor can help keep you in the game. 

*Forecasted average annual returns of COUNTRY Trust Bank Wealth Management

Source: Morningstar and COUNTRY Trust Bank® - See Definitions and Important Information below

COUNTRY Trust Bank® Wealth Management Team

• Chelsie Moore, CFA, CFP® - Director, Wealth Management & Financial Planning
• Kent Anderson, CFA - Portfolio Manager
• Jonathan Strok, CFA - Portfolio Manager
• Michelle Beckler - Investment Analyst
• Samantha Reichert - Investment Analyst